The assumed long-term discount rate is the interest rate used to determine the liabilities of a defined benefit retirement system (system) or pension plan. The assumed long-term discount rate is known by various terms including the investment return assumption and is the rate that is used to adjust a series of future payments to reflect the time value of money. The assumed long-term discount rate is the rate of investment return, typically on an annual basis, that an actuary believes the system will earn in the market on average over a long period of time, such as 30 or 40 years. The assumed long-term discount rate along with application of a funding method and other actuarial assumptions allows for a calculation of liabilities and the determination of what an employer's periodic contribution to the pension plan must be. The goal is to fund promised benefits at some point in the future by making contributions that will earn a return on investment up to that future time. The higher the assumed long-term discount rate is, the lower the liabilities are of a system and the lower the periodic employer contributions are that are required to fund the system.
The actuary will take into consideration the investment allocation of the system when selecting a long-term discount rate to be assumed for the system. Generally, the higher the equity exposure of a system, the higher the assumed long-term discount rate will be. Conversely, a system that has a higher fixed income or bond exposure will likely have a lower assumed long-term discount rate.
The actuary recognizes that the asset gains and losses will occur when the market returns are either higher or lower than the assumed long-term discount rate. However, since the actuary does not select long-term assumptions based on annual gains and losses, the actuary does not try to mimic current market conditions but instead looks at the long term (e.g. 30 or 40 years). During an up market, the assumed long-term discount rate may be lower than actual market returns. During a down market, the assumed long-term discount rate may be higher than actual market returns. Conventionally, there is no recognition by the system employing the assumed long-term discount rate that actual future returns must be higher when there are asset losses in order for the assumed long-term discount rate to be accurate over time. Nor is there recognition by the system employing the assumed long-term discount rate that actual future returns must be lower when there are asset gains in order for the assumed long-term discount rate to be accurate over time.
There are unfortunate consequences to not recognizing the effects that asset gains and losses have on future returns and thereby not adjusting employer contributions accordingly. For example, the extraordinary market returns over the 1990's were on average much higher than the assumed long-term discount rates during the same period. The economic times were good and although the employers had money in their budgets, they generally utilized the asset gains to pay for benefit improvements or employer contribution decreases. However, in the early part of the subsequent decade, the equity markets deteriorated and the investment performance was poor. This caused asset losses that started to drive up the cost of pension plans and required increases in the employer contribution rates at a time when employers had budget deficits and were looking to cut expenditures.